No. The idea that the problems of the financial crisis has been that depositors have become the driving force of risk since the rather successful 1991 FDIC overhaul is wrong. Regardless of what you think of FDIC, the problems that amplified this housing bubble into a global financial crisis are that you had the supercharged credit markets replacing the deposit markets in terms of lending. The deposits at commercial banks, the thing the FDIC haters are putting the blame on, weren’t the ones funneling the money into SIVs – indeed among certain circles you had the opinion that SIVs and the repo markets would replace commercial banks since they did the same thing but were more efficient. But while they were more efficient, they were also way more fragile. These supercharged credit markets were subject to a supercharged bank run. Deposits weren’t anywhere in sight of this problem.

Everyone see that? Now for the FDIC haters, I have a few extra questions:

Financial Literacy – Capital Reserve Mark-To-VaR-Model Edition

So there are a lot of people out there who think that we need to kill the moral hazard of having your savings account insured. Grandma has $12,000 in her savings account, and doesn’t worry about whether or not the bank is solvent – so let’s force her to worry by removing the FDIC protection. This worrying will result in her providing discipline to her bank on their risk. Here’s my question: How will grandma know what to do?

The obvious problem is that the information disclosed in the quarterly reports is really, really poorly targeted to knowing this kind of information. But let’s pretend by magic that the quarterly reports are good enough. Again, here’s the question: how to judge? And don’t give me that “common sense” stuff. Be specific.

I know the simple way you do it, some techniques that I’ve had some training in: You place out the payment structures using monte-carlo simulations with lognormal random walks; you take a metric of correlation in the market, perhaps in a gaussian copula structure and use that to run correlations at each step between the instruments; you take the distribution you generate and apply a “value-at-risk” logic to it, looking at some piece of the tail distribution.

Now are the libertarians saying that a 16-year old who wants to open a savings account for his part-time job will need to know these techniques? I’m very interested in ideas of “financial literacy” – will capital reserving VaR based models be required for the definition of financial literacy? And even if we train a generation of savings-account holders in basic financial engineering techniques, how does this overcome basic Diamond-Dybvig bank run mechanics?

Neo-Rothbardians Party Like It’s 1913

When I listen to the tea-party movement rhetoric, especially when it comes to financial reform, I hear an argument that everything in the financial sector since the Federal Reserve was put into place has been a disaster. This leaves us in a situation where good policy tinkering here or there won’t fix the problem – the problem can only be solved by essentially ripping out the entire banking apparatus.

As I try to see everyone’s ideology at play when it comes to financial regulation, I want to coin the phrase “Neo-Rothbardian” for this approach to financial reform. It’s fairly popular among the teaparty movement. When I read that a book with the title End The Fed is becoming a bestseller, when I see that the largely dismantled New Deal banking regulation is being blamed for this crisis, when I hear the rush to gold and silver, when Joe The Plumber’s favorite books include von Mises and in general when I hear a tone that is opposed to the general idea of modern banking as opposed to having to re-regulate specific new markets that are being created, I hear the tone of Rothbard.

This isn’t your everyday think-tank libertarian speaking through the teaparty movement when it comes to financial reform. I find it interesting, though also disturbing at how easy it is for the financial sector to co-opt. (But I really like the possibility that I’ll hear the phrase “Kochtopus” more in the political sphere.) But this approach takes you to a dead-end quickly.

Because here’s the deal: you can’t kill FDIC without also taking out fractional reserving banking. It’s like other regulatory battles we are having: you can’t have “community ratings” without also having an individual mandate when it comes to health care. In financial reform, I, for instance, don’t think you can have credible resolution authority without getting the OTC derivatives market to trade on a clearinghouse (at the very least). These reforms make each other credible. Rothbard got that about killing FDIC, here he is from 1985:

…in what sense is a bank “sound” when one whisper of doom, one faltering of public confidence, should quickly bring the bank down [subject it to a bank run]? In what other industry does a mere rumor or hint of doubt swiftly bring down a mighty and seemingly solid firm? What is there about banking that public confidence should play such a decisive and overwhelmingly important role?

The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks (mutual-savings and savings-and-loan) have been systematically engaging in fractional-reserve banking…

It is impossible to “insure” a firm, even less so an industry, that is inherently insolvent. Fractional reserve banks, being inherently insolvent, are uninsurable….

Yes, the FDIC and FSLIC “work,” but only because the unlimited monopoly power to print money can “work” to bail out any firm or person on earth. For it was precisely bank runs, as severe as they were that, before 1933, kept the banking system under check, and prevented any substantial amount of inflation.

We are currently in a political environment where making sure that poor people with pre-existing medical conditions will have healthcare is a radical notion, so I run out of language very quickly and have to resort to the italics tag, but this is a really radical notion of how to reform the banking system. Is this what the anti-FDIC people have in mind?

Fix or Kill

This is all a roundabout way of asking the question: do libertarians want to “fix” FDIC, or kill it? Given how much the financial system, employers, and the government have been able to shift risks onto consumers and citizens, does the idea of the risks of having a savings account being absorbed by a social contract really cause people to rage out to the point where it needs to be destroyed?

If they want to make it work better, there are a bunch of little things I would suggest they research: coinsurance, deductibles, policy limits, etc. I might point out the New Dealers original plan was a co-insurance regime, which was scrapped by Congress. Starting to put haircuts on creditors in failed banks is what Miller-Moore amendment does, and it’s definitely a smart start in tackling these problems as they relate to shadow banks.

But is that the goal, better policy? Or is the goal to kill it? Because I have no time for that.

Eh. I could be convinced either way on how the FDICIA did, though I think it didn’t do awful as a baseline – but I’m of the believe that the shadow banking system took off simply because it was hella efficient. Fragile, unstable, but incredibly efficient for the time it was flying. Now how much of it is worth bringing forward into the rest of the 21st century is the real question….

In what ways was it efficient? There were all those middlemen–mortgage originators, banks, SIVs (with 1000-page legal documents), ratings agencies, etc.

I know that bank loans require a lot of intermediation, too, and like you, I’m willing to be convinced either way, but the shadow banking system always struck me as the financial equivalent of a Rube Goldberg device.

The simple answer is that you are actually performing financial intermediation in a private-public partnership, you get the government guarantee for this and only for this. That means a clear line demarcating traditional banking business from everything else, so that nothing other than the public-private partnership is involved. Investment “banking” and hedge funds need not apply.

This means reorganizing the structure of the TBTF’s to reflect this absolute separation. The public/private partnerships are regulated by the FDIC, and get the guarantee. The others (shadow banking system) can swim or sink based on how they handle their capital. However, there also have to be safeguards against their creating systemic risk, since even the blow up of investment banks and hedge funds can cause havoc.

“However, there also have to be safeguards against their creating systemic risk, since even the blow up of investment banks and hedge funds can cause havoc.”

I’ve been spending a lot of time trying to think this part through. Is it a matter of regulating against a certain type of liquidity mismatch risk? If so, doesn’t that imply you’ve guaranteed the scope of their assets then?

Regulating the 21st century is hard! I get why the Neo-Rothbardians just want to go back to the 19th century.

I think you’re forgetting the fact that (i) most commercial paper programs carry a commercial bank guarantee — that’s what got the banks involved in the crisis in 2007. (ii) Repo markets could only be saved by allowing commercial banks to use deposits to fund the repo market in Sept. 08 (see Fed announcements). (iii) securitization “worked” because commercial banks were in the habit of removing bad loans from the vehicles to protect their reputations in the securitization market (making nonsense of the “true sale” status of the loans).

All that shadow banking — including much of what was originated by the investment banks — carried an explicit or implicit commercial bank guarantee. That said, I’m not really of the opinion that ending FDIC insurance is the best solution. I just think it’s important to get the role of the commercial banks in so-called “market-based” lending correct.

“I think you’re forgetting the fact that (i) most commercial paper programs carry a commercial bank guarantee — that’s what got the banks involved in the crisis in 2007…” – Good point csissoko. I tend to agree, I don’t see that putting an end to the FDIC insurance is best either.

It’s a bit of an overstatement to say that fractional reserve banking requires the FDIC. The pre-Fed era was fractional reserve. It came up with all kinds of fancy tricks to mitigate the Diamond-Dybvig problem: collateralized notes, clearinghouse certificates, Secretary Cortelyou’s Treasury management, gold reserves, high capital–and that is just in the US. The Europeans and Japanese, of course, had a central bank. (A gold-standard central bank, admittedly.) I’m not sure that the 19th century was as easy as the neo-Rothbardians thought it was.

The more accurate statement is that these tricks were damned expensive, especially capital and reserve requirements. (Clearing House certificates were cheap, but required skillful management.) FDIC insurance has much less of a social cost. And, as Mike points out, it doesn’t have all that much moral hazard.

It is worth pointing that that granny–if she has an ounce of common sense–will completely ignore Gaussian copulas for a far better metric. She’ll put her money in a “too-big-to-fail” bank. (“Common sense” is an ability to redefine a complex problem into a simple one. It’s not that common.) FDIC insurance is a benefit that inures to small banks.

I agree with Milton Friedman that the FDIC was “the most important structural change in our monetary institutions since at least 1914…” ( The Essence of Friedman, p. 424 ). I also believe that the Govt will intervene in a Financial Crisis. Period. Having said that, I’m in favor of Narrow/Limited/Utility Banking. I keep having to remind people of this, but FDR opposed Deposit Insurance. The Congress passed it. The Chicago Plan signers favored FDIC Insurance as a step towards 100% Reserves. FDIC Insurance was passed in conjunction with Glass-Steagall. Putting those two together, you can see that they are basically Narrow Banking Light. A good book on this is Ronnie J. Phillips “The Chicago Plan & New Deal Banking Reform”.

One last point about Friedman. When Friedman advocates change in a crisis, he points to the example of the FDIC. That’s his “Shock Doctrine”. Read the essay yourself.